How Do Construction Loans Work?

Constructions loans, as the name implies, are loans taken out to finance the construction of a building, such as a home. A construction loan may include the purchase of the land on which the home is being built or it may just cover the cost of the building itself.  

Getting a construction loan

The person will have to research the right type of loan, meaning a loan with the right interest rate for them. In most cases, a bank or other lending institution will not lend more than the borrower can afford to comfortably repay. The borrower in many cases will be expected to place some of their own capital into the construction of the building. The reason for this is so that should the borrower be unable to repay the debt, the lender can then resell the property for more money than was borrowed to finance the construction. This makes resale easier. It also helps borrower to become personally invested in the project. If they are emotionally invested in the construction, then they are more likely to work hard at keeping it afloat and are less likely to run if something were to go bad.

How a construction loan works

Once the loan has been approved, the borrower should pay to lock in the interest rate. Up until the end of construction, the borrower’s payments will be going to the interest on the loan only. Locking the rate ensures that the rate that they are paying will remain stable. It is sometimes possible to change to a lower interest rate even if they are locked, but without the necessity of changing to a higher rate if the rates go higher. This is called a float-down rate. At the end of the construction project, it is possible for the loan to transition into a mortgage at which point the borrower will begin monthly repayments of the loan.